Lesson 3 - Options Terminology

by Uncle Bob Williams

Before we jump ahead, into the strategies, let's first understand the Options Terms and the "Greeks".

We said earlier that Options are like Insurance. Let's explain:

Car Insurance, for example, is like a PUT Option. We pay an annual Premium, and for that year the Insurance company agrees to pay us for the value of the car should it get stolen or damaged. In exchange for the Premium we paid, we can 'put' the value of the car back to the Insurance company. If our car was worth $10,000 and it gets stolen, the Insurance company will pay us $10,000.

A PUT Option works just like the Insurance Policy. Let's say we have Acme stock which is currently selling at $50 per share. We are concerned that the price of the stock will go down, and it will jeopardize the value of our investment. We can buy a PUT Option at the $48 strike, which will expire 2 months from now. We pay a small premium for that PUT Option, say $1.00 per share. If the market price of Acme stock goes below $48 during the next 2 months, we can sell or exercise the Option.

Here is how it works: Imagine that Acme announces some really bad news, and the price of their stock drops down to $42/share, which would be pretty upsetting as it would represent an 16% loss of our investment. But thankfully we purchased a PUT Option to 'hedge' (meaning that we bought a type of insurance called an Option) against a price drop. We can sell our PUT option which will now have a value of at least $6 per share: The Strike of our PUT Option is $48, and the current price of the stock is $42, so our PUT Option has an Intrinsic Value of $6 per share.

If we thought Acme stock was going to continue to drop, we can sell our shares for $42 on the open market, and sell our PUT Option for $6 on the open market = $48 per share. The PUT Option cost us $1 per share, so we are left with $47 per share, which is a lot better than $42. At the end of the day, we would have lost only 6% of our investment, instead of 16% like everyone else.

If we thought that Acme stock was going to go back up, we could still sell our PUT Option for $6 per share, and now if the price of Acme stock goes back up to $50 per share, we already made a healthy profit of $5 per share or 10% of our investment. ($6 Option sale price, minus the $1 that we paid for the Option).

A CALL Option will make money if the price of the stock goes UP. It works the same way as a PUT Option, but in the opposite direction. We don't buy 'insurance' for things that increase in value, but we do make bets.

For example, If Acme stock is current selling at $50 per share and we think the price of the stock will go up, it is possible to place a bet on that hunch using a CALL Option. For example, we can buy a CALL Option at the $52 strike for $1.00 per share, which will expire 2 months from now. If the price of Acme stock goes up to $56 per share before the expiration, then we can sell the CALL Options and keep the profit. In this case, the Intrinsic Value of the Call Option is $4.00 ($56 current price of the Stock, minus the $52 strike of this Option), and since it cost us $1.00 to buy the Option that leaves us with a $3.00 profit per share.

We will dive into the details of the Options terms soon.

Before we do that, let's explain one of the more common Options techniques that we hear about— the "Covered Call".

For example, we have 100 shares of Acme Company stock that is currently trading at $50 per share. It's a stock that we plan holding on to for a while, and we think that the stock price will remain the same or even go down a little. So we decide to make some extra cash on the side and do a "Cover Call": We sell the $53 strike CALL Option, which will expire next month for $0.50 per share. One Options contract equals 100 shares of stock, so in this case we will sell 1 contract. When we sell that CALL Option, our broker will put the money from the sale immediately into our trading account, in this case: $0.50 per share * 100 shares = $50.00. And we say to ourselves, "Sweet! We just made $50 on stock we plan on keeping, and we can do that every month!" As long as the stock price stays below $53, the CALL Option will expire worthless, and we will keep the $50 profit. If however the stock price goes above $53, in this case, we have our 100 shares of stock to protect us. If the price of the stock shoots up to $60 per share, we can sell our stock at $60, and then buy the CALL contract to close it out for $7.00 per share. ($60 price minus $53 strike of our CALL Option equals $7.00 of intrinsic value in the Option that we need to pay to buy it back so we can close it.) So, at the end of the day, we were able to cover the loss of the CALL Option with the sale of our stock, and we ended up cashing out at $53 per share, instead of $60 per share.

So why do some people give Covered CALLs such a bad reputation? It seems that as long as the price of the stock doesn't shoot up past our Short CALL, we can consistently make a little extra money on the side, and a lot of people do.

The reason that people warn about Covered CALLs is that the profit / loss graph of a Covered CALL is the same as selling a Naked PUT (Selling a PUT Option or also called a Short PUT). This means that the fact that we own the stock to cover the potential loss of the CALL doesn't change how much money we lose. We will lose the same amount of money as if we had just sold a PUT Option Short. As long as we are willing to take that kind of risk, we don't need to limit ourselves to doing "Covered Calls" to stocks that we own. Instead, we could write Short Puts on any stock that we thought was stable and our Profit/Loss potential is the same as "Covered Call".

Here is the Profit / Loss Graph of owning 100 shares of stock:

If the price of the stock goes up, we make a profit, if the price of the stock goes down, we have a loss.

Here is the Profit / Loss of a Cover CALL: Own 100 shares of stock, and selling 1 CALL contract (Short CALL):

Note that the Profit / Loss is very similar to owning the stock except that the amount of profit we can make is capped at our Short CALL. We took in a premium for that risk.

Here is the Profit / Loss of a Short PUT (Selling a PUT contract / a Naked PUT):

If the price of the stock goes down, we have the same loss as the Covered CALL, and it is also the same loss as if we had owned the stock. If the price of the stock goes up, we have limited our profit to the amount of premium we took in on the sale of the PUT Contract.

When we understand that the real risk of a Covered CALL is like selling a Naked PUT, it puts both owning stocks and selling Naked Options into a new perspective.

Most investors would never consider selling Naked Options: the amount of risk is significant. It's OK to do Covered CALLs as long as we are aware of the risks. For some investors, they may have stock that they never plan on selling: they might have an emotional attachment to the company and are willing to risk all of their investment for the emotional high they get by owning that particular stock. If we have stock that fits that description, then trying to make a little extra money on the Covered Call at the risk that we won't make a profit if the stock goes up can be OK for some investors.

The same is true for owning stocks, it's great when the stock goes up, but the chance of a stock going down is very real—with only 50/50 odds—and the potential for loss is significant.

We don't trade Covered CALLs at Uncle Bob's Money. At Uncle Bob's Money, we focus on using Options to make trades where our probability of profits is high, the amount of risk we take is both limited and known, and the amount of time that we expose ourselves to market fluctuations is limited.

We've been discussing some of the more common Options terminology, so it will ideally become more familiar. Let's now delve into the different parts of an Option, so when we get to the specific strategies we'll be closer to a complete understanding. Don't worry, we will keep explaining the terms in different ways, and when we are done, these Option terms will be familiar and come as second nature.

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